Investors are experiencing an aftershock late in October and in early November from the unexpectedly high magnitude of financial market losses on residential mortgages, even though they quickly got past the July jolt when they abruptly realized that subprime mortgages were not worth as much as they paid for them. Reed Construction Data has slightly reduced the construction spending forecast for the end of 2007, but most of the impact will be felt in 2008.

The aftershock was set off by announcements that both Merrill Lynch and CitiGroup were adding nearly $10 billion to loss reserves to cover the reduced value of mortgages and mortgage-backed securities. More similar announcements are likely.

Lending Standards are being Tightened Again
Financial managers are aware that the ultimate value of subprime mortgages and the securities that back them is still uncertain. The inevitable mortgage defaults have only begun, with most of the expected losses still in the future. How big the losses are depends on economic growth and home price changes over the next five to six quarters.

After several months of calm, lending standards are being tightened again and lending rates for non-conforming mortgages have risen further above the market benchmark, the 10-year T-Bond yield. Commercial mortgage rates are now 150 to 200 basis points (100 basis points = 1.0%) above the 10-Year T-Bond yield, up substantially from last month and up at least 100 basis points from early July. Jumbo residential mortgage rates have also moved higher in the last few weeks.

Consequences for Construction — Most of the Impact will be on Commercial
The first impact will appear in the November construction spending report due at the end of December, although it is likely to be too small to be measurable. Most of the impact will be on commercial buildings. November construction starts data will be compiled by December 10th and may provide a preview. However, more expensive financing and lowered expectations for building space demand are likely to initially impact plans for projects being prepared for bidding, so that the impact on job-site activity is delayed until early 2008.

This is how the second round of the mortgage mess will play out on the job site. The current cash flow problems of banks and other lenders will be aggravated by the additions to loss reserves, which are direct subtractions from capital. To preserve their capital and meet legal requirements, lenders will have to cut loans by raising credit costs to ration scarce lendable funds. The Federal Reserve Board will counter this quickly — but not before some damage is done — by injecting more funds into the financial market in the form of another federal funds rate cut. This will happen if the need arises.

Longer-term Consequence is more Inflation a Year Ahead
The immediate consequence for construction and other spending early in 2008 will be to cushion any decline in spending. The longer-term consequence of aggressive monetary loosening is more inflation a year ahead. The Federal Reserve Board can postpone and spread around the payback for residential mortgages that never should have been granted, but it cannot make the problem disappear without any pain.

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